Transcript Slides PPT - Tony Yates

What caused the Eurozone
crisis?
Lecture to 3rd year ‘Current Economic
Problems’ group, Spring 2015, Bristol
Tony Yates
Overview of the topic
• What caused the crisis? [this lecture]
– Requiring us to characterise what the crisis was
and how it unfolded
• Evaluating how Eurozone authorities have
responded to the crisis [2nd lecture]
– Unconventional monetary policy, Troika and
limited debt forgiveness, OMTs, banking union,
QE, no fiscal stimulus, ‘structural reform’
Reading
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Reading list for this topic on my homepage
Karl Whelan lecture
Brugel think tank survey.
Piece by the infamous conservative Hans Werner
Sinn putting the ‘German view’.
• Commission of investigation into the banking
crisis in Ireland
• Obstfeld [Pioneer of open economy macro and
finance] review.
What caused the EZ crisis
• Characterising the crisis:
– Political origins of and context to EMU
– Economic gains envisaged for EMU
– Macro-financial received wisdom before the crisis
– Low-frequency crisis ‘timeline’
Crisis diagnoses, 3 views
• Mainstream view
• Two dissident views, considered briefly at the
end:
– Dissident, freshwater view
– Bank for International Settlements view
EMU and EPU, post-war nation
building
• EMU in part a political project to entrench European
union and continental peace.
• A way to end destructive, zero-sum fighting between
European nation states.
• Realise an alternative to reliance on US defence
umbrella in face of perceived Soviet threat.
• Lock in and enhance democratic and institutional gains
from transition out of dictatorship of Spain, Portugal,
Greece + later Communist bloc countries.
• Lead to certain willingness to overlook or colour
economic benefits of monetary union?
Those econ benefits of EMU
• Enhance benefits of price-transparency of the
European single market.
• Lock in Bundesbank mon pol credibility without
sacrifice and credibility problem of FX pegging,
removing inflation bias, and option of
seigniorage.
• Further guarantee fiscal stability, having removed
option of excessive deficit finance with the SGP.
• Old Mundel-Fleming idea of ‘Optimal Currency
Area’.
Pre-crisis macro and financial received
wisdom
• There would not be another global financial
crisis.
• Monetary policy and inflation targeting sufficient
to guarantee macroeconomic stability;
responsible for ‘Great Moderation’
• Highly active fiscal stabilisation not needed, and
in fact hazardous. Automatic stabilisers ample.
• Fiscal union anyway not possible, yet. Monetary
union a stepping-stone.
• We would not hit the zero bound, as Japan did.
Perils of catch-up
• Poor periphery growing fast, large current
account deficits, borrowing to finance real
estate boom too.
• Inflation higher than North, one monetary
policy.
• Banking system sucking in the borrowing
running up large, undiversified risks,
prudential systems overwhelmed.
Borrowing to catch up.
Source: Karl Whelan
Catching-up sovereigns
• Peripheral sovereigns benefit from common borrowing
rates post EMU.
• SGU implementation patchy.
– Laxity tolerated to expand the union
– Some data manipulation by peripherals
– Failure to appreciate implicit financial risks to sovereigns
posed by financial sector
• Understatement of structural deficits
• Under-appreciation of chance of sovereign spreads
opening up again
• Over-estimate of fiscal solidarity implied by the narrow
spreads
Credibility bonanza for peripheral
sovereigns
Source: Karl Whelan
German political/economic context
• Conservative approach to use of monetary
policy for smoothing the business cycle
• Likewise belief in fiscal prudence
• Both partly bi-products of experience of prewar hyperinflation and monetary financing.
‘Never again!’
• ECB adopts conservative ‘price stability’
mandate to conform to German constitution
Northern sovereign misdemeanours
• Not all countries abide by SGP themselves, so
enforcement on South weakened
• They, in part, via their own banks, are engaged in
lending – to Southern sovereigns, and Southern
banks
• Their own banking systems not prepared for the
closure of wholesale funding and securities
markets
• Sovereigns strained by potential banking failure,
and operation of automatic stabilisers.
US sub-prime crisis trigger
• Losses on ‘sub-prime’ mortgages mounted in US.
• Eventually triggered collapse of ABS markets. No-one
knows what a security leaves you on the hook for.
• This triggers collapse of wholesale intermediary funding
markets. No-one knows who is exposed to what, so better
safe than sorry and not lend.
• Banks can’t fund loans, so need to shrink lending. Loans
turning bad, worsening funding prospects. Vicious circle.
Fire-sales of property causing prices to fall. Contraction of
credit hits firms and consumers, demand falls, more loans
stop performing…
• Contagion across countries via international wholesale
funding market for banks and other intermediaries.
Greece: context
• Another fast catch-up country. Easy to overdo
expectations of end-point.
• No pressure for structural reform.
• Bloated public sector workforce; endemic tax
evasion.
• Long history of dysfunctional state. Ottoman
occupation breeds distrust of centre, custom
of evading taxes; get bad public goods in
return, cycle repeats.
Greece: crisis
• Greece: recession hits, Greek banks struggling
for funding, govt bond yields soar due to
expectation they have to stand behind those
banks.
• Increase in bank/govt funding rates make
collapse self-fulfilling.
• Deposit flight from banks, credit crunch, fiscal
tightening from automatic stabilisers.
Ireland – pre-crisis
• Irish current account deficit mirrors rise in
wholesale funding to Irish banks.
• They are borrowing to finance their client’s
commercial and residential property
borrowing..
• Some charts….
Irish current account ‘imbalance’
Could be borrowing to finance
genuinely higher future income.
Actually we’ll see that it’s
borrowing wholesale by
banks….
Source: IMF Article IV on Ireland, 2007
Bank wholesale funding in Ireland
Ratio of deposit to loan
ratio falls, implying
wholesale funding is rising.
Wholesale funding is very
short term, and highly
mobile.
Deposits, although short
term, are usually, outside
of a crisis, very sticky.
Source: IMF Article IV on Ireland, 2007
Commercial property lending in
Ireland
Commercial property
unusually risky as has a very
volatile price.
Fast build up in both kinds of
property lending strains risk
management in banks, and
prudential standards in the
regulator.
Source: Commission of investigation into the banking
sector in Ireland, 2011
Commercial property lending in
Ireland and other countries
Ireland much more exposed precrisis to this peculiarly risky form
of lending – commercial property.
Why are commercial property
prices more volatile?
Perhaps because commercial
property volatile because firm
value is volatile.
Source: IMF Article IV on Ireland, 2007
Ireland-crisis breaks
• Banks in crisis: govt hastily announces 100%
deposit guarantee.
• But it’s a bluff as govt can’t afford it. Markets
call government’s bluff and un from
government bonds.
• Govt can’t roll over its short maturity debt.
• Has to be bailed out by Troika [IMF/EU/ECB]
• Analyse the bail outs in the next lecture.
Spain, Italy
• These countries are large, and are the ones
that really matter.
• Prob no-one cares about Ireland, Portugal,
Greece! Too small.
• But how they are/were dealt with affects how
markets will value Spanish and Italian bank
and sovereign assets.
Italy
• Long stagnation.
• Endemic structural govt deficits.
• Uncompetitive, over-regulated product and
labour markets.
• Tax evasion, systemic extra-state [organised
crime] activity, bad public goods in return.
• Central state young and dysfunctional.
• Bad position to weather large recession and
banking crisis.
Spain
• Very fast catch-up, pre-crisis. Country held back previously
by Franco dictatorship, economic isolation.
• Public finances in good shape before 2008. Even had
‘dynamic provisioning’ ‘macro-pru’ for banks.
• [DP=find more equity-based funding, which you don’t have
to ‘pay back’ if your loan book increases a lot].
• But still sunk by scale of property boom and bust and its
effect on banks and the real economy.
• Inflexible labour markets; extra-state social security
network; Italy-like problems of product market regulation,
tax-evasion.
• Govt avoided bail out, but only just, thanks to OMTs, which
we will discuss in the next lecture.
Spreads reopen
Private debt crisis
socialised via implicit and
explicit guarantees.
Markets question
commitment of North to
keeping Euro together.
Spreads fall after Draghi’s
‘whatever it takes’
Speech on OMTs.
Source: Karl Whelan
Crisis increased
correlation of bank
and sovereign
credit default swap
spreads, on
account of govt
inability to fund
implicit or explicit
bail-outs.
Source: Merler
and Pisanni-Ferry
(2012), BdF.
The crisis – freshwater dissident view
• ‘Freshwater’ derives from – associated with
universities near the Great Lakes in US [eg
Chicago]. [vs ‘saltwater’ – Berkeley, Harvard].
• Source of problem is implicit and explicit bail-outs
and sclerotic supply-side.
• This is what generated accumulation of
inappropriate risks. And the anticipated tax
burden of the bail out is what is depressing
demand now.
• Solution: don’t intervene.
• Sooner you start the pain, sooner things improve.
Mainstream critique of the freshwater
view
• Fwater view is that all fluctuations are
efficient.
• This view at odds with the data on the effects
of monetary and fiscal policy on the economy.
• Sticky prices, wages, financial frictions + more
indicate role for stabilising inefficient cycles.
Cause of the crisis – BIS view
• Bank for International Settlements, Basel,
Switzerland. Central bank for central banks,
and a think-tank.
• Believed build up of real risks in financial
system, increase in asset prices, should have
been dealt with by monetary policy.
• Central banks instead followed inflation
targets too slavishly.
BIS view of the crisis -ctd
• Identified low nominal rates as cause of build
up in risk: ‘the risk taking channel’
• Investors [that’s banks too] try to preserve
nominal rates of return by moving into riskier
assets.
• Form of ‘nominal illusion’ [they don’t
appreciate real returns are not increasing].
Mainstream critique of the BIS view
• Their forecasts of doom were right, but are
like ‘stopped clocks’, right eventually.
• Mon pol has effects only over shorter run.
• Not responsible for 2-3 decade build up of risk
in the real economy.
• Many other more promising culprits.
Mainstream diagnosis of the EZ crisis:
Recap.
• Highly divergent trajectories of EZ economies
suffered with common mon pol.
• Stability and growth pact [SGP] failed to discipline
fiscal authorities.
• Fiscal authorities failed to appreciate or prepare
for implications of implicit bailouts in event of a
crisis; or for the automatic stabiliser impact in a
crisis.
• Prudential failures on funding and lending side of
banks, particularly -but not just- in periphery.
• No fiscal stimulus or transfer when it was needed.